Wednesday 9 October 2024
Ethiopia’s decision to float its currency and liberalise its economy, officially announced on 29 July, has sparked widespread debate and concern, as similar reforms in other African nations have led to unrest. Prime Minister Abiy Ahmed, who compared the move to the “pain of surgery”, now faces the monumental task of steering his nation through this precarious economic landscape while avoiding the fate of countries like Kenya and Nigeria, which have been destabilised by similar reforms. As Ethiopia embarks on what is being called a “transformative” economic shift by central bank governor Mamo Mihretu, there are deeper concerns beneath the surface optimism. The decision to float the birr could carry significant implications that may reshape the nation’s economic sovereignty as Ethiopia, characterised by some as a centrally controlled economy, is now under immense pressure to comply with the demands of international financial institutions.
Hailemelekot Asfaw, the country director for East Africa at the Center for International Private Enterprise recalled Ethiopia’s economic odyssey in an interview with the Addis Ababa-based The Ethiopian Reporter. The country operated a feudal economic system in the mid-20th century before the Derg came to power in 1974 converting the country to a socialist system. “Private property, land, factories, and everything was taken over by the government. For instance, during Derg, a person could not own more than 400,000 birr. People were also not allowed to have more than one house… The government rationed bread and every basic commodity,” said Asfaw.
In 1991, the Ethiopian People's Revolutionary Democratic Front (EPRDF) swept away the Derg and formally committed itself to introducing free market principles in certain parts of the economy but in reality, the state still led, either directly or indirectly holding large stakes in certain sectors. “Despite what it proclaimed, EPRDF used to run even small businesses. The government was in every business sector,” Asfaw told The Ethiopian Reporter. This approach was adopted by Ethiopia’s elites in response to the “failure of neoliberalism” in the late 1980s in Africa to reduce poverty, drive strong growth and infrastructure expansion. In 2011, former prime minister Meles Zenawi wrote a biting critique in an academic paper himself, arguing that the neoliberal paradigm would not “bring about the African renaissance”.
The EPRDF later adopted the “development state” inspired by the significant economic achievements of east “Asian tiger” economies. Comparisons with China began to emerge in the popular press, with prominent American economist Tyler Cowen writing: “Both countries feel secure about their pasts and have a definite vision for their futures. Both countries believe that they are destined to be great.” Zemedeneh Negatu, an Ethiopian businessman said his country was “piggybacking on the best elements of China and South Korea, and perhaps, some aspects of Singapore, with an Ethiopian flavour.”
This was the era in which Ethiopia was Africa’s fastest growing economy “without being dependent on a natural resource boom” like other countries. “Most of the growth can be attributed to public investments in infrastructure and construction,” wrote the celebrated economists Jostein Hauge and Ha-Joon Chang in their assessment. They added: “If there is one African country that is likely to achieve success in economic development through industrialization under the tutelage of a ‘developmental state’, similarly to the East Asian developmental states, it is Ethiopia.”
When Abiy Ahmed came to power he was eager to take the country along a new path. One of the first major policies ushering in a new era was the partial privatisation of Ethio Telecom. Abiy Ahmed’s decision is in line with a precedent set through much of his premiership of giving greater space to market forces – both domestically and internationally – to shape the economy and enter key areas. He hopes to solve Ethiopia’s persistent foreign exchange shortages and chronic inflation, while also attracting much-needed foreign investment.
In July 2024, after months of negotiations and growing economic pressures, the Ethiopian government floated its currency, allowing the birr to be traded at market-determined rates. This policy shift was a key condition for securing a $10.7 billion financial package from the IMF, the World Bank, and other international creditors. The IMF has been a critical player in Ethiopia’s economic “reform” efforts, and the currency float is one of the most significant steps taken as part of a broader package of “reforms” aimed at stabilising the economy and laying the groundwork for sustainable growth.
At present though the situation is delicate. Prime minister Abiy Ahmed likened the currency float to “the pain of surgery endured for healing” but the birr has lost almost half of its value against the US dollar. Javier Blas, an energy and commodities columnist at Bloomberg has informed followers on X to “add Ethiopia to the geopolitical watch list.” Fassil Demissie, an editor at Routledge posted: “The rapid devaluation of the Birr and the implementation of new taxes will lead to increased economic pressure on the middle class and urban poor, potentially exacerbating income inequality and poverty. These conditions can contribute to social unrest, as seen in other countries facing similar challenges.”
The decision to float the birr was not made lightly. Ethiopia had long maintained a fixed exchange rate regime, which provided short-term stability but ultimately led to an overvaluation of the currency. This overvaluation made Ethiopian exports less competitive, exacerbated the trade deficit, and contributed to chronic foreign exchange shortages. The government’s decision to move towards a floating exchange rate was driven by the need to correct these imbalances and create a more competitive and resilient economy. The question really is if Ethiopia can manage and mitigate the negative externalities of the transition. The government has moved to subsidise essential imports such as fuel, fertilisers, medicine and edible oil to support households, but shortages in these basics have led to unrest in other African countries.
Although efforts will be made to cushion the blow for consumers, the costs are too high to guarantee subsidies for everyone. Ethiopia imports over 1 million tonnes of wheat annually, with costs around $400 million when wheat is at its cheapest on international markets, but these costs have exceeded $800 million when prices rise. To keep wheat prices stable, the Ethiopian government would need to draw on its scarce dollar reserves—hence the loan request to the IMF—to subsidise wheat imports. The same would be required for the fertilisers that support the production of domestic wheat, maize, coffee, and flowers—the latter two commodities account for more than 40% of Ethiopia’s exports.
By August 2024, Ethiopia’s annual inflation rate had reached 28%, and the IMF predicted that inflation could rise to 30.1% by the end of the year.
The challenges after the devaluation can be understood by looking at the country’s balance of payments, whose reliance on coffee influences the rest of the economy. Ethiopia’s coffee export revenues, which account for more than one-third of the country's exports, plummeted between 2022 and 2023 due to a sharp drop in purchases from importers. Germany, which imported over 58,000 tonnes of Ethiopian coffee in 2022 (paying $233 million), bought less than half that amount the following year: 23,300 tonnes for $101 million. The decline in demand among other major importers (the United States, China, Japan, and Switzerland) highlights the limitations of an export strategy centred on agricultural products. In the first five months of this year, Germany purchased only 5,600 tonnes of Ethiopian coffee, a 74% drop compared to the same period in 2022. Cheaper Ethiopian coffee, driven by currency devaluation, is unlikely to prompt German importers to significantly increase their purchases: after all, the German economy is stagnant—Volkswagen, one of Germany’s global brands, is considering closing a factory in Germany for the first time in its 87-year history. The weakness of the birr in a situation of lower demand is akin to pushing a string in this sense.
Businesses, too, are feeling the effects of the currency float. Many Ethiopian businesses rely on imports for raw materials and other inputs, and the depreciation of the birr has increased their costs. At the same time, businesses are finding it increasingly difficult to access foreign currency through official channels. The forex shortages that plagued Ethiopia before the currency float have not been fully resolved, and many businesses are resorting to the black market to meet their forex needs. This has further widened the gap between the official and black-market exchange rates, raising concerns about the sustainability of the currency float in the absence of sufficient forex reserves.
Analysts warn that if businesses cannot freely access forex through official channels, the currency float may fail to achieve its intended goals. The gap between the official and black-market exchange rates could widen once again, undermining the government’s efforts to create a more market-driven economy. This could lead to further economic instability, with potentially severe consequences for Ethiopia’s social stability.
Ethiopia’s banking sector is also undergoing significant changes following the currency float. For years, the country’s banks operated in a relatively protected environment, with limited competition from foreign banks and strict controls on foreign exchange transactions. However, the liberalisation of the exchange rate has introduced a new level of competition, as commercial banks are now authorised to negotiate the conversion of birr into dollars. This has led to fierce competition among banks and foreign exchange bureaus, all vying to offer the best rates to businesses and consumers. The entry of foreign banks into Ethiopia’s banking sector is expected to accelerate in the coming months.
In September 2024, the Ethiopian government will submit legislation to parliament allowing foreign banks to operate in the country for the first time. This move is part of a broader effort to liberalise the financial sector and attract foreign investment. Foreign banks are particularly interested in Ethiopia’s large unbanked population—only 46% of Ethiopian adults had a bank account as of 2021, according to the World Bank’s Global Findex Database—and see significant opportunities in providing financial services to this underserved market.
However, the entry of foreign banks also presents challenges for Ethiopia’s domestic banks. Many of Ethiopia’s banks are relatively small and may struggle to compete with larger, more established foreign institutions. Some foreign banks have also raised concerns about the ability to repatriate funds from Ethiopia, given the ongoing foreign exchange constraints. This could limit the extent to which foreign banks are willing to invest in the Ethiopian market, at least in the short term.
The currency float is just one aspect of Ethiopia’s broader economic “reform” agenda. The government has also embarked on an ambitious privatisation programme, with plans to sell stakes in key state-owned enterprises, including Ethio Telecom and several sugar factories. These privatisations aim to attract foreign investment, generate revenue for the government, and improve the efficiency of Ethiopia’s state-owned enterprises.
In addition to privatisation, Ethiopia is preparing to launch its first stock market since the 1970s. The Ethiopian government has been working with the Nairobi Securities Exchange and other partners to establish the Addis Ababa Securities Exchange, which is expected to open by the end of 2024. The stock market is viewed as a key component of Ethiopia’s economic liberalisation strategy, providing a platform for raising capital and trading shares in Ethiopian companies. This could help attract more foreign investment and stimulate economic growth.
The IMF has been a crucial partner in Ethiopia’s economic reform efforts. In exchange for the currency float and other reforms, Ethiopia has secured financial support from the IMF, which is expected to help stabilise the economy during this transition. The IMF’s support will be vital in managing the short-term negative impacts of the currency float, such as inflation and capital flight, and ensuring that the reform process stays on track.
Ethiopia’s decision to float its currency is a necessary step towards tackling the country’s economic challenges. It doesn’t really have another option. Ahmed Soliman, Chatham House’s east Africa researcher has called it a “huge, huge shift”, especially considering where Ethiopia’s economy has been over the last few decades. However, the transition to a market-determined exchange rate will be difficult, and the success of this reform hinges on the government’s ability to manage the risks and challenges ahead.
Inflation remains a major concern, and the government must strike a balance between pursuing economic reform and mitigating the risk of social unrest. Ethiopia isn’t just a poor country but is also mired in multiple conflicts, some of which are on-going, and a large debt burden. The opening of the banking sector to foreign competition brings new opportunities but also significant risks for Ethiopia’s domestic banks. At the same time, the government’s broader economic reform agenda, including privatisation and the creation of a stock market, will require careful management and ongoing international support.
As Ethiopia navigates this uncertain path, the role of the IMF and other international partners will be crucial in ensuring the successful implementation of these “reforms”, enabling the country to emerge stronger and more resilient in the years ahead. The IMF programme – Ethiopia’s eighth since joining the institution in 1945 – sees the currency float as the start of the nation’s journey towards a more open and competitive economy. However, there is cause for concern regarding its reliance on cash crops.
Despite high global coffee prices—caused by heat in Vietnam and insufficient rainfall in Brazil—Ethiopia earned less from exports than in 2021, when prices were much lower. The difficulty of securing fertilizers, rising fuel costs, and logistical challenges will be additional hurdles for coffee producers trying to transport their products to global markets—highlighting the critical importance of sea access and port use for Ethiopia's economy. In addition, the EU intends to implement an anti-deforestation plan that, under current conditions, would close the EU market to many of the small-scale coffee farmers who are central to the Ethiopian economy. The plan, which includes a traceability scheme to ensure that no deforestation has occurred on the land where coffee is grown, will come into effect this December. Ethiopia’s smallholder farmers lack the resources to make the technological investments required to meet the EU's standards, further complicating their situation in the short term.
Ethiopia exemplifies the challenges faced by countries at the bottom of global value chains: relying on raw material production leads to periodic crises that a currency devaluation alone cannot resolve. Even if the country produces more coffee than ever, any recovery in production in Brazil or Vietnam, coupled with weak demand in wealthy markets, will result in oversupply, causing coffee prices to crash. If, during the IMF’s four-year adjustment programme, the prices of petrol, wheat, or fertilisers rise and export revenue has not allowed the central bank to build up a dollar cushion, the pressure to maintain subsidies will exacerbate problems related to the shortage of dollars and the value of the birr. Once again. Should the country reverse its progress towards industrialization, particularly in value-added sectors like the textile industry, it risks emerging economically weakened, with less export diversification. Exactly the opposite of what the IMF adjustment plan claims it intends to achieve.